Since the Reserve Bank of Australia started jacking up the official cash rate in October 2009, there has been a great deal of attention paid to which lender offers the cheapest variable rate.
Interest rates have become the allimportant factor in a home loan, and it’s generally believed that as long as you get a low rate, you are on the right track. Nearly all variable home loans have some repayment flexibility, the minimum being the ability to make extra repayments when you are able to.
Choosing a home loan can, in a sense, be viewed as a trade-off between interest rate and repayment flexibility: you can choose a low rate with limited flexibility or a relatively high interest rate and a greater level of repayment flexibility, providing the opportunity to reduce the total cost of the loan.
The question many borrowers face is whether they should pay the higher rate to get the additional features, or if a low interest rate is best for them.
To a large extent, the answer lies in the borrower’s financial situation and to what extent they will be able to take advantage of the greater flexibility. To put it simply: it is not worth paying extra for something you are not likely to use?
Home loans which allow you to pay your income into your home loan account and withdraw it as required come under a variety of names – all-in-one accounts, revolving lines of credit, home loans with a salary account and 100% offset accounts.
With a 100% offset account you do not actually put your money into the home loan account; instead you place it into a linked account. The balance in the 100% offset account is deducted from the balance in the home loan account to determine the amount on which interest is charged.
The difference between having one account or two lies in the details, while the interest calculated will be the same. In the interests of simplicity, the term ‘all-in-one’ home loan will be used. All-in-one home loans allow the borrower to deposit their income into their home loan account with the knowledge they can access it when they want.
This reduces the outstanding balance on which interest is calculated as soon as you are paid. Interest is calculated daily, so even if some of your pay is withdrawn after only one day it has still contributed to reducing the amount of interest you incur. The longer you are able to keep the money in the home loan account, the less interest you will be charged.
One of the most effective ways to take advantage of this is to use a credit card with interest-free days (see right for more details). It is possible to extend the number of interest-free days by having multiple credit cards with staggered statement dates. When one credit card nears its statement date you switch to another with a later statement date, extending the amount of time before you have to withdraw money from your home loan account to pay off the credit card balance.
However, this strategy only works if you are disciplined and are able to track your expenses and keep your spending under control.
Access to your all-in-one account The ways in which you can access the money you have paid into your home loan account varies from loan to loan. The number of ways you can access accounts includes internet access, over the counter, via ATMs, cheque books, EFTPOS, over the phone and at agencies such as post offices.
Giving the borrower easy access to their funds when required has traditionally been an advantage banks, building societies and credit unions have had over other lenders, as offering transaction accounts to customers was already part of their core business. This has now changed, with mortgage managers providing these facilities on their loans through other institutions, primarily the banks.
The line of credit facility
A line of credit allows you to access the equity you have built up in your home to borrow for other purposes, at home loan rates, when you need to. Your equity in your home is the difference between its value and the amount you owe on it. For example, if your home is worth $500,000 and you owe a total of $300,000, your available equity is $200,000.
A line of credit, secured by your home, allows you to have access to this equity as you require it: for example, when an investment opportunity arises or if you want to buy a new car. Some products are also promoted as providing the opportunity to reduce the interest expense and term of your loan using its repayment flexibility.
It is important to recognise that the flexibility of either type of loan allows it to be used with different goals in mind – to repay your loan as quickly as possible, to consolidate all your debts or, with some lines of credit, manage the cash flow of your business.
The main differences between products lie in the interest rate, the access to the account and the associated costs, plus the amount of credit to which you have access.
While lines of credit can be an effective means of consolidating your debt at a relatively low interest rate, they can also lead to you making little progress towards owning your home if you do not use them in a disciplined manner. Every time you access your line of credit, you reduce the equity in your property.
Differences in access
Assuming you intend to pay off your home loan as fast as possible while paying as little interest as possible, you are faced with a choice of a wide variety of home loans.
It is not possible to say which loan will best allow you to do this without taking into account your personal financial situation and how you will be able to take advantage of different products.
In nearly all cases, it is possible to make additional repayments on variable rate loans without penalty. Some lenders charge a fee, often called a deferred establishment fee, if you pay the loan out in full within a certain time frame. The ability to access additional repayments at a later date varies a great deal.
The amount of access to additional repayments made on variable rate loans can be roughly divided into three groups:
- No access to additional repayments
- A redraw facility
- Flexible access to additional repayments
1 No access
No access means it is not possible to access additional repayments which have been made under the terms and conditions of the loan, so any amount above the set repayments paid cannot be withdrawn later. For example, if you have an offset facility and you pay extra into your mortgage, you won’t be able to access this unless you have a redraw facility. The offset facility allows you to put money in and take money out of it, and it’s linked to the mortgage. However, unless your mortgage has a redraw facility you cannot access any additional repayments you make into your loan. The majority of loans described as basic variable loans do not have a redraw or offset facility.
2 Redraw facility
A redraw facility is a feature which allows the borrower to withdraw additional repayments which have been made, subject to certain terms and conditions. The terms and conditions vary significantly between loans.
When comparing redraw facilities keep an eye out for these:
- Number of free redraws per year
- Fee per redraw
- Max number of redraws per year
- Minimum redraw amount
- Maximum redraw amount
The number of free redraws per year is the number of times you can withdraw additional home loan repayments you have made each year, at no charge.
This varies significantly between lenders, from none to unlimited.
For example, Mortgage House, Resi Mortgage Corporation and Commonwealth Bank of Australia are three lenders which allow unlimited free redraws on their standard variable loans.
The fee per redraw is the charge per withdrawal after you have used your quota of free redraws. For example, if you are allowed two free redraws per year and the fee per redraw is $20, you will be charged $20 for your third redraw of the year and any thereafter. The fee per redraw can be as much as $50.
The minimum redraw amount is the smallest amount you can withdraw. The minimum amount per redraw is generally between $500 and $5,000.
This is an important factor to consider as it determines how flexible the redraw facility is (ie, if the minimum amount allowed is high, you may decide not to redraw), and is where they differ from all-in-one accounts and 100% offset accounts.
The maximum redraw amount is usually the total of additional payments which have been made. Some lenders set the maximum at the total of additional repayments less one month’s payment.
A redraw facility can be a valuable feature as it allows you to make additional repayments which can significantly reduce the total amount of interest you repay on the loan, with the knowledge that you can access the money at a later date. The table shows, however, that a simple redraw facility is not flexible enough to enable you to use your home loan as your main financial tool, ie, putting all your income into it and withdrawing only what you need as required.
In some cases, the factor restricting the frequency of use is the fee per redraw, in others it’s the number of redraws you can make each year. Generally, though, the most restrictive factor is the minimum amount that can be redrawn. If you place all your income into your loan account you could find yourself in the ludicrous situation of having to withdraw a minimum of $2,000 to go to the corner shop for a newspaper or a loaf of bread! There is some potential to use a redraw facility in association with a credit card, which you would pay off once a month.
If you put the majority of your pay into your home loan, keeping an amount aside to cover necessary cash expenses, and make as many transactions as required on your credit card, you can make one redraw a month to pay off your credit card.
However, this is not the intended purpose of redraw facilities and if you try to use them in a way they were not designed for it is quite possible you will end up in a financial squeeze at one time or another.
Redraw facilities should be considered as more a form of security which allows you to make additional lump sum repayments when you come into extra money, with the knowledge that you can access it at a later date if required.
3 Flexible access
The ability to pay all your income into your home loan, or a linked account, and access it as required is now being offered by an increasing number of lenders. Three important factors to consider in relation to the access you have to your funds are:
- The different ways you can access your funds
- The number of free transactions per month
- The cost per transaction after the free transaction limit has been exceeded
There are many ways you can access accounts these days: you can move your money around over the telephone or on the internet, withdraw money at a range of retail stores (even the corner shop in some instances), EFTPOS, and post offices act as agencies for some financial institutions.
When looking to use your home loan as your primary financial account, it is important to consider your needs. The main thing you are trying to do is leave as much of your money as you can in your loan account for as long as possible. If an account only allowed you to make branch withdrawals, achieving this aim could mean spending most of your lunch break each day in a queue at the bank withdrawing money for that day and the following morning.
Alternatively, if you withdraw an amount once a week when you get paid to cover the week’s expenses and avoid wasting your lunch hour, you have gained little or no benefit from having this type of account.
All-in-one accounts allow you to use your home loan as your main financial product. In fact this is the way you will get the most benefit from it.
There is no point having another savings account or transaction account with money in it, unless it is earning a higher interest rate than the rate you are paying on your home loan. (You also need to consider the tax you will pay on the interest you earn with the savings or transaction account. Funds offsetting your loan balance don’t incur taxable interest, despite earning an effective interest rate equal to the home loan interest rate.)
To use an all-in-one account as your main financial tool it has to meet your needs. For example, if you write cheques, it has to have a cheque book facility.
The cost of making frequent, small withdrawals to leave as much money in your account as possible also needs to be considered. Excess withdrawal fees charged on transaction accounts are a common cause of concern and, for many people, can surpass the interest you earn. Most all-in-one home loan accounts, or home loans with a linked 100% offset account, allow a number of free transactions each month, after which you are charged for each transaction.
Many institutions charge different amounts for different types of transactions. For most institutions, the listed fee applies to their own ATMs, plus those of affiliated institutions. The fee may be higher if you use a non-preferred ATM.
Also, in many cases, transactions from non-preferred ATMs incur a charge, whether or not you have exceeded your limit.
All the loans offer at least some free transactions per month. However, it is important to keep any monthly account-keeping fee in mind. It is also a good idea to consider how many free transactions you actually need.
As mentioned, one of the most effective ways of using these types of loans is in conjunction with a credit card with interest-free days, and paying off the credit card in full at the end of the interest-free period.
If you were able to put all of your expenses on your credit card you would only need one free transaction per month to transfer money from your home loan to your credit card account.
How much flexibility do you really need?
Generally speaking, as the interest rate rises so does the flexibility of the loan. To put things into perspective, say you are paying a rate 1.5% lower for a basic, no-frills loan compared with the rate charged on a feature-laden standard variable loan.
On a $100,000 loan over a period of 25 years, where only the regular repayment is made each month, this equates to interest of approximately $640 a month versus $730 a month, or in terms of total interest over the term of the loan, approximately $91,000 versus $120,000.
To be better off with the more flexible loan you have to be able to use the greater flexibility to create significant savings.
The main factor this will depend on is the amount of income you are able to leave in the home loan account and for how long.
The point that makes evaluating the difference between flexible and more traditional loans very difficult is the actual amount which is paid towards the loan per period.
As long as you are able to make additional payments at no cost, regardless of the loan, the more you pay, the faster you will pay off the loan and the less interest you will incur.
Having your salary paid directly into your loan account or a 100% offset account may in effect lead to you paying more towards your home loan because of a natural reluctance to withdraw money from your loan account, but this is really only a psychological effect. The same amount could be paid on a basic variable loan, although you would have to make the additional payments yourself.
The factor which needs to be measured to effectively compare the loans which allow you to offset all your income against the loan balance with those that do not, is the reduction in the interest charged due to the offset effect. This is rather difficult to do, especially when you are taking advantage of a credit card with interest-free days.
To come out ahead you need to be able to reduce your loan balance for a period of time such that the amount on which interest is calculated reduces the amount of interest you pay, so it is less than it would have been if you had taken out a loan without this facility.